The American business model part 1: Corporate Governance

Russian business has emerged from its semi-criminal, post-Communist origins: already films like Oligarch and Brigada look like elegies for a vanished past. Robber barons, grown rich on stolen state assets, talk the language of corporate responsibility; their children study ethics at American business schools.

America is the model, because it is the most successful economy in the world. But the post-Enron ‘American model’ is itself in crisis. The economist Joseph Stiglitz describes it in terms which would almost fit Russia: –‘corporate greed, accounting scandals, public influence mongering, banking scandals, deregulation, and the free market mantra, all wrapped together’. Over my next four columns I will discuss four distinctive aspects of the American business model: corporate governance, transparency, the role of lawyers, and ‘scientific management’.

Corporate governance is about having honest systems run by honest people. Where ownership of a company is widely dispersed, the problem arises of how the theoretical owners are to control the managers who actually run the company. The classical solution is the Board of Directors, whose most important function is to stop managers stealing investors’ money. Every Board has two key committees, Audit and Compensation –the first to prevent falsification of accounts and asset stripping, the second to stop greedy managers paying themselves too much.

Until recently, though, non-executive directors were largely cronies of the Chief Executive Officer (who was normally chairman of the Board). Business ‘insiders’ typically served on a half a dozen or more boards, picking up a fee or retainer from each. They had neither the time nor inclination to probe too deeply into their companies’ affairs.

Following the recent US corporate scandals, it is increasingly accepted that each board should have a majority of ‘independent’ or ‘outside’ directors and a Nominations committee to propose directors; that the posts of chairman and CEO should be split; and no non-executive director should serve on more than four boards. Of these, the most important, but also the most troubling, is the requirement for ‘independence’.

In Russia, ‘independent’ directors are seen as representatives of minority shareholders. This made sense after the privatisations of the 1990s, which left managers in control of the bulk of a company’s assets. But as the ownership of Russian companies becomes more diversified, the American definition will become more useful. ‘Independence’, as defined by the Sarbanes-Oxley Act of 2002, excludes not only employees, but also anyone who has had any recent commercial relationship with the company. The ‘independent’ director is expected to protect the interests of all shareholders against a greedy management.

The American model is not problem-free. A truly independent board will find it hard to understand its company’s business. It may have the wish, but not the knowledge, to exercise adequate control. Sarbanes-Oxley requires at least one member of the audit committee to be a qualified accountant, and other independent members to attend training programmes. But the inherent problem is that the directors are part-time, while managers are whole time.

The other problem is that independence is defined by narrow technical criteria, whereas what is most needed is independence from the particular business culture. An independent director must be sensitive to ‘reputational risk’ – the risk that certain well-established business practices, even if ‘legal’, will be perceived as illegitimate, leading to investor flight, and more intrusive regulation. This has recently happened in the mutual fund industry. No training in ‘ethics’ can provide the right kind of sensitivity, only wide knowledge of life. But such people are even less likely to have the exact business knowledge needed to fulfil their supervisory role. Enthusiasm for the American model should not blind us to its limitations.